For a taxpayer who has made an honest mistake, all penalties will seem excessive! The taxpayer in Total Technology (Engineering ) Ltd v Revenue and Customs Commissioners ([2012] UKUT 418 (TCC), published on 9 January 2013) appealed against a 5% default surcharge penalty of £4,260 for the late payment of a VAT liability on the grounds that the penalty was disproportionate to the infringement.

The taxpayer had a good record of compliance. However, a persistent computer error had previously resulted in the underpayments to HMRC. Under the VAT penalty regime, such defaults trigger two consequences: HMRC imposes a “default surcharge” penalty and then moves the taxpayer to the next level of “default surcharge” for 12 months.

For the first default, the surcharge penalty is nil; and in this case the taxpayer’s underpayment was also very small (£476 from a £125,769 liability). HMRC put the taxpayer onto a 2% default surcharge for the next 12 months, but imposed no penalty.

For the taxpayer’s second default, an underpayment of £331 from a £108,957 liability, the penalty resulting from the 2% default surcharge fell below HMRC’s de minimis threshold of £400. HMRC collected no penalty, but still raised the default surcharge to 5% for the next 12 months.

Therefore, when the taxpayer’s entire VAT liability of £85,205 was paid late during this 12 month period, HMRC imposed the full 5% default surcharge penalty (£4,260). However, the payment was late by just a single day.

It is easy to sympathise with the taxpayer: the two earlier errors were very minor and not deliberate, having been caused by faulty software. Without these minor errors, a nil penalty would have been applied as a first default. However, UK VAT law does not recognise any default as being “de minimis”: the rate of a default surcharge penalty simply increases with each failure to pay or submit the VAT return within the 12 month period. Furthermore, given that payment was late by just a single day, the taxpayer thought the penalty was disproportionate to the infringement and appealed.

The legal principle of proportionality has its origins in the fact that European VAT penalties are not harmonised, so that each state must set its own penalty regime “which they deem necessary to ensure the correct collection of VAT and to prevent evasion” (EC VAT Directive 2006/112/EC, Article 273). This is rather open-ended, but European caselaw has confirmed that each state’s “administrative measures or penalties must not go beyond what is strictly necessary for the objectives pursued and a penalty must not be so disproportionate to the gravity of the infringement that it becomes an obstacle to the freedoms enshrined in the Treaty” (Paraskevas Louloudaki, C-262/99).

The defence that a default surcharge penalty was disproportionate had already succeeded in Enersys Holdings UK Ltd v Revenue and Customs Commissioners ([2010] UKFTT 20 (TC)). The taxpayer had suffered a default surcharge penalty of £131,881 for submitting its VAT return late by a single day. The scale of the penalty and the trivially small delay in submission were important in the Tribunal discharging the penalty as disproportionate.

Total Technology (Engineering) Ltd’s case was less clear-cut. The Tribunal was asked to find that the default surcharge system was flawed and that therefore the specific penalty was disproportionate. Even though the Tribunal decided that the default surcharge penalty regime as a whole was not fatally flawed (albeit while making some criticisms of the regime), they felt that an individual penalty could still be considered to be disproportionate.

In this case, however, they did not find that this was the case. The Tribunal noted that the penalty was relatively small (£4,260) and, even if it were higher than a Tribunal might have imposed, the penalty could not be said to be disproportionate.

Default surcharge penalties should always be considered in light of the taxpayer’s intention in defaulting and the scale of the infringement. If the penalty automatically imposed by HMRC for a default is high, it might be possible to have it cancelled on the grounds that it is disproportionate to the infringement; however, each case will need to be considered on its specific facts.